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September 2008 will be a month to remember for decades to come and will likely have a more dramatic impact on the structure of the world’s financial system than any other since the Depression. This month we have seen, among other stunning developments,

the U.S. Treasury commit up to $200 billion to rescue Fannie Mae and Freddie Mac, and use its discretion over its Exchange Stabilization Fund to implement a $50 billion guaranty program for money market mutual funds;

the Federal Reserve extend an emergency $85 billion loan to American International Group and expand its array of liquidity lending programs to include new extended term auction facilities, a new asset-backed commercial paper lending facility to assist struggling money market mutual funds, and extensions of credit to the broker-dealer subsidiaries of the last remaining independent Wall Street investment banks, Morgan Stanley and Goldman Sachs, in connection with their conversions to bank holding companies;

the SEC issue broad emergency orders to curb naked short selling and nearly all short selling in financial stocks, while throwing in the towel on its consolidated supervised entities program; and

The amazing, however, gave way to the astounding today, as the parade of troubled bank resolutions continued through the weekend, both in the United States and overseas, and the Administration’s proposed $700 billion bailout legislation was defeated in the House of Representatives.

This afternoon, the House — by a 205-228 vote, with 95 Democrats and 133 Republicans voting against the bill — rejected the Administration’s proposed Emergency Economic Stabilization Act of 2008. Stock market indexes had been dropping all day in anticipation of a tight vote in the House, and plunged severely after the rejection. The White House, Treasury and Congressional leaders continue to express resolve to pass some form of economic stabilization legislation, but it is not clear what form that legislation may take or when it could be voted on.

The House vote merely capped an already busy day in the world’s financial system. This morning, the FDIC, Citigroup Inc., and Wachovia Corporation announced that Citigroup would acquire the banking operations of Wachovia, the fourth largest bank holding company in the United States, with open-bank assistance from the FDIC.1 This marks the FDIC’s first use of its open-bank assistance powers since the passage of the Federal Deposit Insurance Corporation Improvements Act (FDICIA) in 1991, and by far the largest resolution in the FDIC’s history.

Also this morning, the U.K. Treasury announced the nationalization of troubled mortgage bank Bradford & Bingley plc, and the sale of its retail deposit franchise and certain of its assets to the Abbey National plc subsidiary of Banco Santander SA, which also had previously agreed to acquire another troubled U.K. lender, Alliance & Leicester plc.2

Separately, the governments of Belgium, the Netherlands and Luxembourg injected a total of €11.2 billion in various units of Fortis, with Belgium investing €4.7 billion in exchange for a 49 percent interest in Fortis Bank NV/SA, its Belgian arm, the Netherlands investing €4.0 billion in exchange for a 49 percent interest in Fortis Bank Nederland Holding N.V., and Luxembourg investing €2.5 billion in the form of a loan that converts into a 49 percent interest in Fortis Banque Luxembourg S.A.3 The terms of the rescue contemplate the sale of Fortis’ recently acquired interest in ABN Amro Bank NV.

In Germany, it has been reported in the press that the German government, subject to German parliamentary approval, and a consortium of private banks have agreed to provide up to €35 billion of credit guarantees to prevent the failure of Hypo Real Estate Holding AG, one of Germany’s largest real-estate lenders.4 Also the Icelandic government, citing short-term funding issues, announced that it has agreed to inject €600 million into the country’s third largest bank, Glitnir, in exchange for a 75 percent ownership stake.5 That transaction is subject to stockholder approval.

Finally, this morning, in response to “continued strains in short-term funding markets,” the Federal Reserve announced that it was increasing the size of its 84-day maturity Term Auction Facility (TAF) auctions, from $25 billion to $75 billion per auction, holding two special forward TAF auctions in November totaling $150 billion to provide additional term funding over the calendar year-end, and increasing its swap authorization limits with foreign central banks from $290 billion to $620 billion.6

As the financial market turmoil continues, the face of banking in the United States and around the world is undergoing profound change. Healthy banks elsewhere in the world are making strategic acquisitions and investments, and struggling banks are desperately seeking capital or negotiating rescue packages. In the United States, Citigroup, JPMorgan Chase and Bank of America have taken advantage of unique opportunities to cement their dominance of the U.S. commercial banking system. After completion of their pending acquisitions, those three will control nearly 30 percent of domestic bank deposits in the United States and will have leading market positions in nearly every banking and financial market segment. Meanwhile, the two remaining large Wall Street investment banks, Goldman and Morgan Stanley, have raised over $20 billion of fresh capital as they convert to bank holding companies.

Citigroup/Wachovia Transaction

What Is Citigroup Actually Acquiring?

Citigroup’s press release states that the parties have “reached an agreement-in-principle” for Citigroup to acquire all of Wachovia’s banking subsidiaries, including Wachovia’s “retail bank, corporate and investment bank and wealth management businesses.” Citigroup is not acquiring Wachovia Corporation itself, Wachovia’s interest in its Evergreen Asset Management unit or its Wachovia Securities joint venture with Prudential.

The announcements vary in their level of detail, but it appears clear that Wachovia Corporation (which expects to change its name to Wachovia Securities) will remain a public company with its existing common and preferred shares outstanding and will continue to operate its asset management, retail brokerage and certain portions of its wealth management businesses, including the Evergreen Asset Management and Wachovia Securities businesses.

Under the terms of the agreement-in-principle, Citigroup states that it will pay Wachovia approximately $2.16 billion in Citigroup stock and will assume Wachovia’s existing senior and subordinated debt (presumably including junior subordinated debt issued by Wachovia in trust preferred transactions), totaling approximately $53 billion. Since Wachovia will become a significant Citigroup stockholder in the transaction, two Wachovia directors will join Citigroup’s board.

Citigroup also announced that it “expects to raise $10 billion in common equity in connection with this transaction and reduce its quarterly dividend to 16 cents per share, effective immediately, to maintain the company’s strong capital position,” and that it “expects to realize more than $3 billion of annualized expense synergies through the consolidation of overlapping functions.”

The announcements also state that the transaction has been approved by the Citigroup and Wachovia boards of directors, but will be subject to approval by Wachovia’s shareholders (presumably as a sale of substantially all of the assets of Wachovia Corporation). The Citigroup announcement also states that the transaction remains subject to definitive documentation, to “the occurrence of the closing by December 31, 2008,” regulatory approvals and “other customary closing conditions.”

What Assistance Is the FDIC Providing?

The FDIC has agreed to provide certain loss protection in connection with approximately $312 billion of Wachovia’s mortgage-related and other assets. According to Citigroup’s announcement, Citigroup will be responsible for the first $30 billion of losses on the portfolio, and it “expects to record these expected losses under purchase accounting upon closing of the transaction.” Citigroup will also be responsible for the next $12 billion in losses, subject to a maximum of $4 billion per year for the next three years. The FDIC has agreed to be responsible for any further losses on the portfolio.

As compensation for the FDIC’s assistance, Citigroup has agreed to issue to the FDIC an unspecified number of shares of preferred stock and warrants having a “combined value of approximately $12 billion.”

Pending completion of the acquisition, the Federal Reserve Bank of Richmond announced that it “stands ready to provide liquidity as needed.”7

How Is This Transaction Different from the Failures of IndyMac and Washington Mutual?

IndyMac, Washington Mutual and Wachovia vividly illustrate the range of powers available to the FDIC to resolve problem institutions. With assets of $32 billion, IndyMac was, at the time, the largest FDIC failure in two decades, but it has since been dwarfed by Washington Mutual, with over $300 billion in assets, and Wachovia, with over $600 billion.

In connection with its appointment as receiver for IndyMac Bank, F.S.B., the FDIC formed a new bridge bank, IndyMac Federal Bank, FSB, for which the FDIC was appointed conservator and to which the FDIC transferred all of the failed bank’s insured deposits and substantially all of its assets.8 As conservator, the FDIC is operating the bridge bank “to maximize the value of the institution for a future sale and to maintain banking services in the communities formerly served” by the failed bank. Although the final cost of IndyMac to the FDIC’s Deposit Insurance Fund will not be known for several years, the FDIC has estimated the total cost may be as high as $8 billion, due, in part, to the significant amounts of Federal Home Loan Bank borrowings at IndyMac.

Last Thursday, the FDIC announced that JPMorgan Chase & Co. was acquiring all of the banking operations of Washington Mutual in a closed bank transaction that required no FDIC assistance.9 In exchange for $1.9 billion in cash paid to Washington Mutual’s banking subsidiaries, JPMorgan Chase acquired substantially all of the assets of Washington Mutual’s banking subsidiaries and assumed all of their deposits, including their uninsured deposits, all of their “qualified financial contracts,”10 and their outstanding covered bonds and other secured debt.11 JPMorgan Chase did not, however, acquire or assume any of the unsecured senior or subordinated debt, or preferred stock, of Washington Mutual’s banking subsidiaries, and did not assume any liabilities of their holding company. The FDIC has subsequently indicated that it “does not anticipate that equity and subordinated debt holders will receive any recovery on their claims,” but because JPMorgan Chase assumed all of Washington Mutual’s deposits without FDIC assistance, the FDIC’s Deposit Insurance Fund will not experience any loss on the resolution of Washington Mutual.

As noted above, Wachovia represents both the largest open-bank rescue in U.S. history and the first time the FDIC has used its open-bank assistance powers since 1992.12 By statute, the FDIC can provide open-bank assistance only if the FDIC determines that open-bank assistance is the least costly alternative to the insurance fund of all possible resolution methods and that the cost to the deposit insurance fund is not increased because assistance benefits shareholders or other creditors of the institution.13 Historically, it has been difficult for the FDIC to meet these standards in openbank assistance transactions.

However, the FDIC may deviate from the least cost requirement if, upon the written recommendation of two-thirds of the FDIC’s board of directors and two-thirds of the Federal Reserve Board, the Treasury Secretary (in consultation with the President) determines that a least cost resolution “would have serious adverse effects on economic conditions or financial stability” and that open-bank assistance “would avoid or mitigate such adverse effects.”14 In its announcement of the Wachovia transaction, the FDIC states that “in consultation with the President, the Secretary of the Treasury on the recommendation of the Federal Reserve and FDIC determined that open bank assistance was necessary to avoid serious adverse effects on economic conditions and financial stability,” thereby satisfying the statutory requirements for a non-least-cost open-bank assistance transaction.

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